Answers to Textbook Questions and Problems
CHAPTER 2
The Data of Macroeconomics
Questions for Review
1.
GDP measures the total income earned from the production of the new final goods and services in the
economy, and it measures the total expenditures on the new final goods and services produced in the
economy. GDP can measure two things at once because the total expenditures on the new final goods
and services by the buyers must be equal to the income earned by the sellers of the new final goods and
services. As the circular flow diagram in the text illustrates, these are alternative, equivalent ways of
measuring the flow of dollars in the economy.
2.
The four components of GDP are consumption, investment, government purchases, and net exports.
The consumption category of GDP consists of household expenditures on new final goods and services,
such as the purchase of a new television. The investment category of GDP consists of business fixed
investment, residential fixed investment, and inventory investment. When a business buys new
equipment this counts as investment. Government purchases consists of purchases of new final goods
and services by federal, state, and local governments, such as payments for new military equipment.
Net exports measures the value of goods and services sold to other countries minus the value of goods
and services foreigners sell us. When the U.S. sells corn to foreign countries, it counts in the net export
category of GDP.
3.
The consumer price index (CPI) measures the overall level of prices in the economy. It tells us the
price of a fixed basket of goods relative to the price of the same basket in the base year. The GDP
deflator is the ratio of nominal GDP to real GDP in a given year. The GDP deflator measures the prices
of all goods and services produced, whereas the CPI only measures prices of goods and services
bought by consumers. The GDP deflator includes only domestically produced goods, whereas the CPI
includes domestic and foreign goods bought by consumers. Finally, the CPI is a Laspeyres index that
assigns fixed weights to the prices of different goods, whereas the GDP deflator is a Paasche index that
assigns changing weights to the prices of different goods. In practice, the two price indices tend to
move together and do not often diverge.
4.
The CPI measures the price of a fixed basket of goods relative to the price of the same basket in the
base year. The PCE deflator is the ratio of nominal consumer spending to real consumer spending. The
CPI and the PCE deflator are similar in that they both only include the prices of goods purchased by
consumers, and they both include the price of imported goods as well as domestically produced goods.
The two measures differ because the CPI measures the change in the price of a fixed basket whereas
the goods measured by the PCE deflator change from year to year depending on what consumers are
purchasing in that particular year.
5.
The Bureau of Labor Statistics (BLS) classifies each person into one of the following three categories:
employed, unemployed, or not in the labor force. The unemployment rate, which is the percentage of
the labor force that is unemployed, is computed as follows:
Unemployment Rate =
Number of Unemployed
´100 .
Labor Force
Note that the labor force is the number of people employed plus the number of people unemployed.
6.
Every month, the Bureau of Labor Statistics undertakes two surveys to measure employment. First, the
BLS surveys about 60,000 households and thereby obtains an estimate of the share of people who say
they are working. The BLS multiplies this share by an estimate of the population to estimate the
number of people working. Second, the BLS surveys about 160,000 business establishments and asks
how many people they employ. Each survey is imperfect; so the two measures of employment are not
identical.
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Problems and Applications
1.
From the main bea.gov Web page click on the interactive data tab at the top, select GDP, begin using
the data, section 1, and then table 1.1.1. Real GDP grew at a rate of 2.2 percent in quarter 4 of 2014.
When compared to growth rates of −2.1 percent, 4.6 percent, and 5 percent for the first three quarters
of 2014, the rate of 2.2 percent was slightly below average. From the main bls.gov Web page select the
data tools tab, then top picks. Check the box for the unemployment rate and retrieve the data. The
unemployment rate in March 2015 was 5.5 percent, which was about equal to the natural rate of
unemployment, or the long run average rate. From the main bls.gov page, select the economic releases
tab, then inflation and prices. Access the report for the CPI. In February 2015, the inflation rate for all
items was 0 percent, and if food and energy were excluded the rate was 1.7 percent. The inflation rate
was below average and below the Federal Reserve’s target of 2 percent.
2.
Value added by each person is equal to the value of the good produced minus the amount the person
paid for the materials needed to make the good. Therefore, the value added by the farmer is $1.00 ($1 –
0 = $1). The value added by the miller is $2: she sells the flour to the baker for $3 but paid $1 for the
flour. The value added by the baker is $3: she sells the bread to the engineer for $6 but paid the miller
$3 for the flour. GDP is the total value added, or $1 + $2 + $3 = $6. Note that GDP equals the value of
the final good (the bread).
3.
When a woman marries her butler, GDP falls by the amount of the butler’s salary. This happens
because GDP measures total income, and therefore GDP, falls by the amount of the butler’s loss in
salary. If GDP truly measures the value of all goods and services, then the marriage would not affect
GDP since the total amount of economic activity is unchanged. Actual GDP, however, is an imperfect
measure of economic activity because the value of some goods and services is left out. Once the
butler’s work becomes part of his household chores, his services are no longer counted in GDP. As this
example illustrates, GDP does not include the value of any output produced in the home.
4.
a.
b.
c.
d.
e.
5.
The airplane sold to the U.S. Air Force counts as government purchases because the Air Force is
part of the government.
The airplane sold to American Airlines counts as investment because it is a capital good sold to a
private firm.
The airplane sold to Air France counts as an export because it is sold to a foreigner.
The airplane sold to Amelia Earhart counts as consumption because it is sold to a private
individual.
The airplane built to be sold next year counts as investment. In particular, the airplane is counted
as inventory investment, which is where goods that are produced in one year and sold in another
year are counted.
Data on parts (a) to (f) can be downloaded from the Bureau of Economic Analysis. Go to the bea.gov
Website, click on the interactive data tab at the top, select GDP, begin using the data, section 1, and
then table 1.1.5. Choose the “modify the data” option to select the years you in which you are
interested. By dividing each component (a) to (f) by nominal GDP and multiplying by 100, we obtain
the following percentages:
1950
1980
2014
a. Personal consumption expenditures
64.0%
61.3%
68.5%
b. Gross private domestic investment
18.8%
18.5%
16.4%
c. Government consumption purchases
16.9%
20.6%
18.2%
d. Net exports
0.2%
–0.5%
3.1%
e. National defense purchases
7.6%
6.3%
4.4%
f. Imports
3.9%
10.3%
16.5%
(Note: The above data was downloaded April 3, 2015, from the BEA Web site.)
Among other things, we observe the following trends in the economy over the period 1950–2015:
a. Personal consumption expenditures have been around two-thirds of GDP between 1980 and 2015.
b. The share of GDP going to gross private domestic investment remained fairly steady.
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6.
c.
d.
e.
f.
The share going to government consumption purchases rose sharply from 1950 to 1980.
Net exports, which were positive in 1950, have been negative since that time.
The share going to national defense purchases has fallen.
Imports have grown rapidly relative to GDP.
a.
b.
g.
h.
GDP measures the value of the final goods and services produced, or $1,000,000.
NNP is equal to GNP minus depreciation. In this example, GDP is equal to GNP because there are
no foreign transactions. Therefore, NNP is equal to $875,000.
National income is equal to NNP, or $875,000.
Employee compensation is equal to $600,000.
Proprietors’ income measures the income of the owner, and is equal to 150,000.
Corporate profit is equal to corporate taxes plus dividends plus retained earnings, or $275,000.
Retained earnings is calculated as sales minus wages minus dividends minus depreciation minus
corporate tax, or $75,000.
Personal income is equal to employee compensation plus dividends, or $750,000.
Disposable personal income is personal income minus taxes, or $550,000.
a.
i.
c.
d.
e.
f.
7.
Nominal GDP is the total value of goods and services measured at current prices. Therefore,
(
) (
2010
2010
2010
2010
Nominal GDP2010 = Photdogs
´ Qhotdogs
+ Pburgers
´ Qburgers
= ($2  200) + ($3  200)
= $400 + $600
= $1,000.
(
) (
2015
2015
2015
2015
Nominal GDP2015 = Photdogs
´ Qhotdogs
+ Pburgers
´ Qburgers
)
)
= ($4  250) + ($4  500)
= $1,000 + $2,000
= $3,000.
ii.
Real GDP is the total value of goods and services measured at constant prices. Therefore, to
calculate real GDP in 2015 (with base year 2010), multiply the quantities purchased in the
year 2015 by the 2010 prices:
(
) (
Real GDP2015 = P2010
´ Q2015
+ P2010
´ Q2015
hotdogs
hotdogs
burgers
burgers
)
= ($2  250) + ($3  500)
= $500 + $1,500
= $2,000.
Real GDP for 2010 is calculated by multiplying the quantities in 2010 by the prices in 2010.
Since the base year is 2010, real GDP2010 equals nominal GDP2010, which is $10,00. Hence,
real GDP increased between 2010 and 2015.
iii. The implicit price deflator for GDP compares the current prices of all goods and services
produced to the prices of the same goods and services in a base year. It is calculated as
follows:
Implicit Price Deflator2015 =
Nominal GDP2010
=1
Real GDP2010
Using the values for Nominal GDP2015 and real GDP2015 calculated above:
Implicit Price Deflator2015 =
$3,000
$2,000
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= 1.50.
This calculation reveals that prices of the goods produced in the year 2015 increased by 50
percent compared to the prices that the goods in the economy sold for in 2010. (Because 2010
is the base year, the value for the implicit price deflator for the year 2010 is 1.0 because
nominal and real GDP are the same for the base year.)
iv. The consumer price index (CPI) measures the level of prices in the economy. The CPI is
called a fixed-weight index because it uses a fixed basket of goods over time to weight prices.
If the base year is 2010, the CPI in 2015 is measuring the cost of the basket in 2015 relative to
the cost in 2010. The CPI2015 is calculated as follows:
CPI 2015 =
(P2015
´ Q2010
) + (P2015
´ Q2010
)
hotdogs
hotdogs
burgers
burgers
(P2010
´ Q2010
) + (P2010
´ Q2010
)
hotdogs
hotdogs
burgers
burgers
$16,000,000
$10,000,000
= 1.6.
=
This calculation shows that the price of goods purchased in 2015 increased by 60 percent
compared to the prices these goods would have sold for in 2010. The CPI for 2010, the base
year, equals 1.0.
8.
b.
The implicit price deflator is a Paasche index because it is computed with a changing basket of
goods; the CPI is a Laspeyres index because it is computed with a fixed basket of goods. From
(7.a.iii), the implicit price deflator for the year 2015 is 1.50, which indicates that prices rose by 50
percent from what they were in the year 2010. From (7.a.iv.), the CPI for the year 2015 is 1.6,
which indicates that prices rose by 60 percent from what they were in the year 2010.
If prices of all goods rose by, for example, 50 percent, then one could say unambiguously that
the price level rose by 50 percent. Yet, in our example, relative prices have changed. The price of
hot dogs rose by 1020 percent; the price of hamburgers rose by 33.33 percent, making hamburgers
relatively less expensive.
As the discrepancy between the CPI and the implicit price deflator illustrates, the change in
the price level depends on how the goods’ prices are weighted. The CPI weights the price of goods
by the quantities purchased in the year 2010. The implicit price deflator weights the price of goods
by the quantities purchased in the year 2015. Since the quantity of the two goods was the same in
2010, the CPI is placing equal weight on the two price changes. In 2015, the quantity of
hamburgers was twice as large as hot dogs, so there is twice as much weight placed on the
hamburger price relative to the hot dog price. For this reason, the CPI shows a larger inflation rate
– more weight is placed on the good with the larger price increase.
a.
The consumer price index uses the consumption bundle in year 1 to figure out how much weight
to put on the price of a given good:
CPI2 =
($2 ´10) + ($1´ 0)
($1´10) + ($2 ´ 0)
(P
=
(P
) (
)+(P
2
red
´ Q1red + P2green ´ Q1green
1
red
´Q
1
red
1
green
´Q
1
green
)
)
= 2.
According to the CPI, prices have doubled.
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b.
Nominal spending is the total value of output produced in each year. In year 1 and year 2, Abby
buys 10 apples for $1 each, so her nominal spending remains constant at $10. For example,
(
) (
Nominal Spending2 = P2red ´ Q2red + P2green ´ Q2green
)
= ($2  0) + ($1  10)
= $10.
c.
Real spending is the total value of output produced in each year valued at the prices prevailing in
year 1. In year 1, the base year, her real spending equals her nominal spending of $10. In year 2,
she consumes 10 green apples that are each valued at their year 1 price of $2, so her real spending
is $20. That is,
(
) (
Real Spending2 = P1red ´ Q2red + P1green ´ Q2green
)
= ($1  0) + ($2  10)
= $20.
Hence, Abby’s real spending rises from $10 to $20.
d.
The implicit price deflator is calculated by dividing Abby’s nominal spending in year 2 by her real
spending that year:
Implicit Price Deflator2 =
Nominal Spending 2
Real Spending 2
$10
$20
= 0.5.
=
Thus, the implicit price deflator suggests that prices have fallen by half. The reason for this is that
the deflator estimates how much Abby values her apples using prices prevailing in year 1. From
this perspective green apples appear very valuable. In year 2, when Abby consumes 10 green
apples, it appears that her consumption has increased because the deflator values green apples
more highly than red apples. The only way she could still be spending $10 on a higher
consumption bundle is if the price of the good she was consuming fell.
9.
e.
If Abby thinks of red apples and green apples as perfect substitutes, then the cost of living in this
economy has not changed—in either year it costs $10 to consume 10 apples. According to the CPI,
however, the cost of living has doubled. This is because the CPI only takes into account the fact
that the red apple price has doubled; the CPI ignores the fall in the price of green apples because
they were not in the consumption bundle in year 1. In contrast to the CPI, the implicit price
deflator estimates the cost of living has been cut in half. Thus, the CPI, a Laspeyres index,
overstates the increase in the cost of living and the deflator, a Paasche index, understates it.
a.
The labor force includes full time workers, part time workers, those who run their own business,
and those who do not have a job but are looking for a job. The labor force consists of 70 people.
The working age population consists of the labor force plus those not in the labor force. The 10
discouraged workers and the 10 retired people are not in the labor force, but assuming they are
capable of working, they are part of the adult population. The adult population consists of 90
people, so the labor force participation rate is equal to 70/90 or 77.8 percent.
b.
The number of unemployed workers is equal to 10, so the unemployment rate is 10/70 or 14.3
percent.
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c.
The household survey estimates total employment by asking a sample of households about their
employment status. The household survey would report 60 people employed. The establishment
survey estimates total employment by asking a sample of businesses to report how many workers
they are employing. In this case the establishment survey would report 55 people employed. The 5
people with 2 jobs would be counted twice, and the 10 people who run their own business would
not be counted.
10. As Senator Robert Kennedy pointed out, GDP is an imperfect measure of economic performance or
well-being. In addition to the left-out items that Kennedy cited, GDP also ignores the imputed rent on
durable goods such as cars, refrigerators, and lawnmowers; many services and products produced as
part of household activity, such as cooking and cleaning; and the value of goods produced and sold in
illegal activities, such as the drug trade. These imperfections in the measurement of GDP do not
necessarily reduce its usefulness. As long as these measurement problems stay constant over time, then
GDP is useful in comparing economic activity from year to year. Moreover, a large GDP allows us to
afford better medical care for our children, newer books for their education, and more toys for their
play. Finally, countries with higher levels of GDP tend to have higher levels of life expectancy, better
access to clean water and sanitation, and higher levels of education. GDP is therefore a useful measure
for comparing the level of growth and development across countries.
11. a.
Real GDP falls because Disney World does not produce any services while it is closed. This
corresponds to a decrease in economic well-being because the income of workers and shareholders
of Disney World falls (the income side of the national accounts), and people’s consumption of
Disney World falls (the expenditure side of the national accounts).
b. Real GDP rises because the original capital and labor in farm production now produce more wheat.
This corresponds to an increase in the economic well-being of society, since people can now
consume more wheat. (If people do not want to consume more wheat, then farmers and farmland
can be shifted to producing other goods that society values.)
c.
Real GDP falls because with fewer workers on the job, firms produce less. This accurately reflects
a fall in economic well-being.
d.
Real GDP falls because the firms that lay off workers produce less. This decreases economic wellbeing because workers’ incomes fall (the income side), and there are fewer goods for people to
buy (the expenditure side).
e.
Real GDP is likely to fall, as firms shift toward production methods that produce fewer goods but
emit less pollution. Economic well-being, however, may rise. The economy now produces less
measured output but more clean air. Clean air is not traded in markets and, thus, does not show up
in measured GDP, but is nevertheless a good that people value.
f.
Real GDP rises because the high school students go from an activity in which they are not
producing market goods and services to one in which they are. Economic well-being, however,
may decrease. In ideal national accounts, attending school would show up as investment because it
presumably increases the future productivity of the worker. Actual national accounts do not
measure this type of investment. Note also that future GDP may be lower than it would be if the
students stayed in school, since the future work force will be less educated.
g.
Measured real GDP falls because fathers spend less time producing market goods and services.
The actual production of goods and services need not have fallen because but unmeasured
production of child-rearing services rises. The well-being of the average person may very well rise
if we assume the fathers and the children enjoy the extra time they are spending together.
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